Taxing the rich: could pensions be taxed?

After the furious debate about a possible mansion tax yesterday, the government is now said to be instead considering removing tax relief on pension contributions for the highest earners. How would it work and could it raise more money?
Polly Curtis, with your help, finds out. Get in touch below the line, Tweet
@pollycurtis or email
polly.curtis@guardian.co.uk.

Yesterday, Reality check attempted to assess the relative merits of 50p tax rate on people earning above £150,000 compared with a mansions tax after Vince Cable suggested that the Liberal Democrats were negotiating a switch. Today there are signs from both sides of the coalition that a different wealth tax is now being considered instead of the mansion tax. It would involve removing tax relief on pension contributions from people earning over £150,000 a year. The suggestion comes in the Times and the FTand was repeated by the BBC's Nick Robinson on the radio this morning.

The Times reports:

Top earners are at risk of losing generous tax breaks on their pension contributions after David Cameron and Nick Clegg agreed a truce over the so-called mansion tax.

Liberal Democrats accept that their chances of winning Mr Cameron's approval for a tax on top-end properties is unlikely to bear fruit. Instead, the Government is examining new curbs on the tax relief given to higher earners, particularly those earning more than £150,000 a year.

Analysis

This ONS table, which we used in yesterday's blog, shows what people's wealth is made up of. It surprised me that among the richest people, pension wealth outstrips property wealth, suggesting that it could be a better target. But the description of what the government is considering is to remove tax relief on pension contributions for people earning above £150,000, rather than increasing taxes on pensions pots.

Breakdown of aggregate wealth by deciles and components. Source: ONS Public Domain

How pension taxes work

I asked Richard Murphy, the anti-poverty campaigner, accountant and tax expert, to explain how taxes on pensions currently work. He said:

If I decide to make a contribution to a pension (I'm self employed) I say to my pension company I want to pay £5,000 this year. There are two forms of tax relief: one is at source and one at higher rate. So if I decide to pay £5,000, I actually pay £4,000 and and get topped up 20% in tax relief. If I'm higher rate tax payer then I put that payment into my tax return and as a result I get tax relief at 40% so I get another 1k of tax saving. At the moment there are lifetime limits of around £1.4m. For those over £150,000 there is an annual limit to their contribution of £50,000. This means their tax bill goes down by 25k. People earning over £150,000 get a benefit of £25,000 at a time when the government is saying that the maximum any family can get in welfare benefits is £26,000.

When you come to retire, your pension schemes requires you to buy an annuity, a way of paying you back over your expected life. That's the money you paid in, plus interest. You get get taxed on those payments. The reason you get taxed is that you didn't pay at the time you earned it. It's deferred tax. But if you were liable to higher rate taxes when you earned it, you are likely to pay basic rate when you receive it.

How much would it raise?

Murphy went away and calculated how much tax removing relief on those earning above £150,000 would raise. His answer was £840m. This is his working:

The latest available data [pdf] on those paying pension contributions, split by tax band, relates to the tax year 2009-10. This suggests that 201,000 people earning over £150,000 made pension contributions totaling £3,129 million (£3.1 billion) in that year. I have estimated maybe 10% of those would have been prevented by the cap on annual contributions of £50,000 in work to be published shortly, leaving net contributions now of maybe £2.8 billion, all likely to enjoy 50% tax relief.

If that relief were restricted to 20% and assuming no behavioural change then tax relief at 30% on £2.8 billion or thereabouts would be removed at a saving of £840 million.

If the restriction were pushed down to, say £100,000 of income (above which level the personal allowance removal now applies) then the proceeds increase. Those in the £100,000 to £150,000 tax bracket make pension contributions of about £1.7 billion a year. Halving tax relief on these contributions would raise another £342 million a year assuming no behavioural change.

Tax avoidance

Murphy also said that by removing tax relief for higher earners, it could cut down on tax avoidance. He said:

If you take off pension tax relief at £150,000 they will not tax avoid as much as they are. People stuff their pensions to avoid paying tax. Instead, they will take the cash and pay their taxes. At the moment people earning £150,000-200,000 – and the evidence is a bit weak – is that people aren't maximising their pension contributions anyway. If you tax pension contributions for those earning over £150,000 that is double taxation. But double taxation is a normal part of tax. We tax income then spending it's normal. The number of people earning over £150,000 is relatively small and candidly, they aren't my concern at the moment.

However, the other notable view on avoidance is that if people are rich enough to pay for the best tax lawyers, they can usually find way of minimising how much they pay. John Kay, the very well respected economist who writes for the Financial Times, summed it up on the Today programme this morning. Asked about pension taxes, he said:

You could get a bit more tax that way but the truth is there is a fantasy that we can get lots of money by [taxing pensions] and the truth is as with a lot of the taxes on high earners, when we try to tax them, what we're trying to tax will disappear.

I'm going to see what other evidence I can find. What do you think? Would this be a fair replacement for the 50p tax rate? Do you know of any evidence for or against it? Do get in touch.

11.25am:

Is removing pension relief an adequate replacement for the 50p tax rate?

If Murphy is right and removing tax relief on contributions would save the country £840m a year, how does that compare with what is brought in by the 50p tax rate? The revenues from the 50p tax rate have not been made public, though it's likely that the Treasury and HMRC have some idea of the receipts from the first year, because the deadline for self-assessment for that year was the end of January. Predictions vary wildly. The best estimate Reality check has previously found was that:

The Treasury predicts that over the next five years the 50p tax rate will raise £5.3bn more than it would have raised if the top rate of tax had remained at 45p, and £12.6bn more than it would have raised if the top rate had stayed at 40p.

There is also an ONS prediction, in this pdf here (last table) which is that 308,000 people will pay over the 50p tax rate, contributing £47bn in this year alone.

But the Institute for Fiscal Studies has said that it could end up raising nothing at all because of the range of ways high earners could avoid paying it.

The potential savings of £840m from removing pension relief for the highest earners compares is small fry compared with highest estimates of 50p tax revenues, the ONS's annual figure of £47bn for 2011-12, but significant if the IFS is right and it ends up bringing in nothing.

We won't know for sure how much the 50p tax rate revenues are until the budget so it's difficult to make a comparison now.

I've just been speaking with Carl Emmerson, deputy director of the IFS, to get his view on the removal of pension relief to tax higher earners. He said:

Clearly you are hitting broadly a similar set of people to the 50p tax rate by removing pension relief. When the government lowered the pension contribution cap from £200,000 to £50,000 they raised just over a couple of billion. That gives us a scale. Many more people would be affected by this.

There are very good reasons for making pension savings attractive. We need people to save more although we almost certainly make it too generous at the moment. I would like them to consider a cap on tax free savings. I don't see why people should squirrel away £1.5m a year. You can take a quarter of that tax free. Do we really think people should take £350,000 out of a pension that has never been taxed in the first place? Cutting the annual contributions hits high wealth people, but it also hits people who want to make one big contribution. They might be people who are selling a business before retiring and want in a one off saving for retirement. They won't be able to. Actually there might be a number of people whose incomes aren't hugely high but they wanted to make one large payoff. If that person hasn't taken advantage on much tax saving yet, you're removing the incentive to do so. I think cutting lifetime limit would be a better way.

11.35am:

Correction

Thanks for comments below the line. Just to clarify in response to @Zigster and @RClayton, the £50,000 annual limit on contributions and lifetime limits apply to everyone, not just the 50p taxrate earners who earn above £150,000.

On the issue of the lifetime limits, the Pensions Advisory Service says here that lifetime limits are set at £1.8m in this year and £1.5m next year.

Thanks for helping to clarify.

12.56pm:

Summary

Our best estimate is that removing tax relief on pension contributions could save the government £840m. This doesn't account for any behavioural changes that people make to avoid paying taxes. It's impossible to compare this with the 50p tax rate receipts because these are so disputed with estimates ranging from zero to £47bn. We'll return to this subject when the government publishes the total receipts for the first tax year, expected at the budget.

Potentially, however, taxing pension contributions could be more profitable for exchequer than introducing a mansion tax. Pension wealth outstrips property wealth in the richest households. But the government would have to be wary of unintended consequences. While taxing pensions would prevent some people ploughing money into their savings to avoid paying income tax, it could also catch people who never usually save but want to make a one-off large payment for their retirement, such as through the sale of their business.